Choice%20of%20Models

1
Choice of Models
P.V. Viswanath
Valuation of the Firm
2
DDM vs FCFE

• Both DDM and FCFE are focused on valuing equity
  directly.
• FCFE is defined as the residual cashflow that
  could be paid out to shareholders as dividends
  without affecting future cashflows
• If so, dividends should equal FCFE
• Then, why might the two reach different
  conclusions?

3
DDM vs FCFE

• There might be various reasons why a firm might
  decide to pay more or less dividends than the
  FCFE per share.
• In a complete model, these uses for cash should
  also be incorporated. However, to the extent
  that the model is incomplete, these additional
  uses of cash should be taken into account outside
  the model.
• If an FCFE model is used for valuation, then
  adjustments to value should be made to compensate
  for deviations between potential dividends (from
  an FCFE perspective) and actual optimal
  dividends.

4
Reasons to pay more or less dividends

• Desire for stability
• Future Investment Needs
• Tax factors
• Signaling
• Managerial Self-interest

5
Adjustments to FCFE Value

• If dividends differ from FCFE because management
  chooses to keep dividends stable, this may not
  affect firm value, except to the extent that
  higher idle cash levels may be maintained .
• In this case, we would compute the value of the
  firm using a FCFE model and then adjust value
  downards.

6
Adjustments to FCFE Value

• If dividends paid are lower because cash is kept
  aside for future investment needs, then the value
  to the firm of cash in hand may be greater than
  the actual exchange value of the cash.
• In this case, we could compute equity value using
  FCFE and then add back an additional amount to
  adjust for this incremental value of cash.

7
Adjustments to FCFE Value

• If managerial self-interest causes higher than
  optimal values of cash to be kept on hand, and
  correspondingly lower levels of dividends to be
  paid out, an FCFE approach would overstate the
  value of the firm under current management.
• However, the FCFE valuation would be useful if
  the analyst believes that the firm might be ripe
  for a takeover.
• In this case, the manager would take a weighted
  average of the dividend and the FCFE approaches,
  weighting the FCFE value by the probability of
  the firm being acquired.

8
FCFE vs DDM

• If we are going to use an FCFE approach and then
  adjust up or down, why not start with the DDM
  method and adjust down or up?
• The FCFE approach explicitly relates the
  cashflows to the underlying accounting decision
  variables, such as leverage, net working capital
  marketing decisions such as higher profit margin
  versus higher volume and macro variables such as
  the growth rate of the economy and the sector.
• The analyst is therefore forced to make all of
  his/her assumptions explicit.
• This ensures that no unwitting false assumptions
  are being made.

9
FCFE vs. FCFF

• Basic accounting principles imply that the sum of
  equity and debt (interpreted broadly to include
  other liabilities as well) equals the value of
  the firm.
• In principle, then, the two approaches should
  lead to the same equity valuation.
• If so, how do we choose between the two?

10
FCFE vs FCFF

• If a firm can be expected to change its capital
  structure in the future in an unpredictable or
  complex way, then FCFF might be a better
  approach.
• If the value of debt is easy to compute, then
  FCFF might be a simpler way to approach the value
  of the equity